Small Business

Buying a Franchise: Potential and Precautions

by Dianne Molvig
/ January 10th, 2011

Chances are, you've visited at least one franchise business in recent weeks. Perhaps you got your brakes fixed at Meineke® or stopped by The UPS Store® to send a birthday present.
Have you thought about buying a franchise? If so, you could choose from lots of options. "People often think franchising is just for the food service industry," says Matt Haller, director of communications for the International Franchise Association, Washington, D.C. "But according to U.S. Census Bureau data, nearly 300 different business format categories use the franchise model. It's everything from hotels, to accounting and tax services, to lawn and garden stores, to hair salons, to wedding planning services...anything that's replicable."
It's precisely because franchise choices are so abundant that you need to do in-depth research before investing in one, cautions Robert Purvin, chairman/CEO of the American Association of Franchisees and Dealers, San Diego, and author of "The Franchise Fraud: How to Protect Yourself Before and After You Invest."
"If you flip through a franchise directory and put your finger down on any page," Purvin says, "nine times out of 10 you won't have a clue what that particular company is. There's a lot of chaff with the wheat."

Know what you're getting into

When you buy a franchise, you become an investor—franchisee—who operates a business. You don't own the business, but you gain the right to use the owner's—franchisor's—business model and collect proceeds from your franchise for a set time period—say, 10 years. At the term's end, you might renew the franchise or sell it. Renewals aren't automatic.

A franchisee needs to stick to the franchisor's way of doing business.

You'll pay an initial franchise fee to the franchisor. Such fees "are all over the map," Haller says, "from thousands to hundreds of thousands of dollars." Other start-up costs include rent, equipment, initial inventory, insurance, and so on. Once you're up and running, you'll pay an ongoing royalty payment based on your gross income, and you might need to pay into the franchisor's advertising fund.
Keep in mind that it will take time to get your franchise business off the ground. It's a good idea to have enough savings to cover at least six months of living expenses.
Opening a franchise, like any small business, poses risks to you, the investor. Minimize those risks by asking lots of probing questions up front, Purvin suggests. "The promise of franchising is appealing," he says. "The franchisee can invest in a company that's established a great reputation, and the franchisor gets a motivated manager who's invested in the business. In such cases, it's a win-win all the way around. Most of the opportunities out there, however, are not proven commodities and established trade names. So you have to be careful."

Assess yourself, too

One of the first steps is to do an honest self-assessment to determine if you're franchisee material. What kind of business experience do you have? What are your skill sets? What types of businesses would you enjoy operating? Can you afford the investment? How many hours are you willing to work?

Initial franchise fees are 'all over the map, from thousands to hundreds of thousands of dollars.'

"Some people think running a franchise won't be a lot of work," Haller says. "They think the franchisor will practically run the business for them. All they have to do is pay the franchise fee up front and then sit back and watch the money roll in. But in franchising, like anything else, hard work pays off."
Remember, too, that a franchisee doesn't call all the shots. You'll need to stick to the franchisor's way of doing business. Can you live with following someone else's model? If, for instance, you've always dreamed of owning a restaurant, will you bristle at being unable to make menu changes as you wish?

Sifting through the choices

To learn what franchise possibilities are out there, you can turn to such sources as Entrepreneur.com or the International Franchise Association's directory. Attending a franchise exposition allows you to talk with several different franchisors gathered under one roof.
You also could hire a franchise broker to help you find a franchise to buy. Be aware, however, that brokers often work for franchisors and get paid if they complete a sale. Hire a reputable broker who will look out for your interests. Check references. And remember, you don't need a broker; you can do the initial legwork yourself.

Count on spending months doing research before you buy a franchise.

Once you've narrowed your franchise choices, you're ready to scrutinize each candidate. For that purpose, the key resource is the franchisor's disclosure document. Under the federal Franchise Rule, enforced by the Federal Trade Commission, you must receive this document at least 14 days before you sign a contract or pay any money to the franchisor or an affiliate of the franchisor.
The disclosure document provides such information as:

The franchisor's background;

The company's litigation history;

Information about any past bankruptcy;

Initial and ongoing costs to franchisees;

Restrictions, such as what goods or services you sell and where you sell them;

Conditions for termination;

Training and advertising support for franchisees; and

Current and former franchisees.

The last on this list is an extremely valuable resource. Experienced franchisees can give you the inside story. How successful is their business? What do they like and dislike about working with the franchisor?
Ask the franchisor about financing, too. Some offer in-house financing; some steer franchisees to certain lenders. How much freedom do you have to choose where you borrow? Could you go to your credit union?
It's also smart to hire a lawyer to review the contract and an accountant to examine the company's financial statements, business plan, and so on.
Count on spending months doing research before you buy a franchise. You'll boost the odds of making a sound decision. "While franchising offers potential," Purvin says, "you have to do your due diligence to determine if a franchising opportunity truly is an opportunity."